It is an interesting academic question for Dr. Bernanke.  “Perhaps we should consider asset prices in our monetary policy after all?”  Nice to be considering that idea now, when it is too late.  The Fed has toyed with the idea in the past, often obliquely through the wealth effect, and how asset price inflation affects the creation of credit in banks.  Consider this post from RealMoney:

		David Merkel
		The Media Overstated Greenspan’s Point
		8/26/2005 1:36 PM EDT

Tony, you probably have more experience than me in this, so if you disagree after I write this, I defer to you.

I’m not sure the media didn’t get Greenspan’s point, but merely cast it in the most sensationalistic way. That the FOMC uses asset prices in making decisions is nothing new; the 1999 transcripts indicated how they used them with respect to the wealth effect.

Secondarily, though they haven’t stated it as plainly, when asset markets have an effect on depositary institutions, the Fed has a responsibility to protect the depositary institutions; the only real debate is whether it should be done through regulatory or monetary policy means. Cramer prefers regulatory means (boost regulatory capital held against risky loans), and I would agree, except that the Fed for political reasons doesn’t like to hold a smoking gun. That’s why they didn’t raise margin rates during the Nasdaq bubble, and why they are conducting a very quiet campaign through the bank examination process to put the fear of God into bank CEOs.

Where the media errs is that the FOMC would focus on assets solely. It’s just one criterion among many for a FOMC that has been notably elastic in their decision-making process (and monetary policy) during Greenspan’s tenure.

Partly, I see Greenspan’s comments as partly about the past to the present, but also pointing the way he would go in the future, if he had the opportunity. That said, barring unusual circumstances (i.e. a dilatory President Bush) he only has three FOMC meetings remaining … what Greenspan thinks about the future conduct of monetary policy is irrelevant, if the new Fed chairman thinks differently.

Position: None, but all of the likely successors to Greenspan worry me, and that is saying a lot…

I’ve argued in the past that both asset and goods/services price inflation should influence monetary policy.  I’m no great fan of fiat money, but if you are going to have fiat money, you must regulate the growth and nature of credit in order to make the system work in the longer-run.  Better we should move to a gold standard (after the crisis) or something like it.

Get the government out of the money and credit business.  They have not done well at it.  We would have more recessions/panics, but they would be shorter and sharper, but much easier for the system as a whole to recover from.  Under a gold standard, we could not build up the kind of leverage that we have done now, or at the Great Depression.

So, Professor Bernanke, that’s a really interesting academic point about asset prices and monetary policy, but there are no bubbles to avoid now, and it is not possible to reflate a bubble, short of massive monetary inflation, leading to price inflation of real assets.  Monetary policy works through stimulating healthy sectors of the economy; unhealthy sectors face credit spreads so large that moves by the Fed are useless, unless they themselves lend to or buy bad debt from the damaged sectors, with losses getting washed to taxpayers through reduced/negative seniorage.

And, if I may say it plainly… I think the governments and central banks of the developed world are going to find out that they are smaller than the size of the credit problems, which will lead to:

• A severe credit-driven recession, and/or,
• Significant socialization of the financial system (much more than what has been done so far), and/or
• Insolvency of several major developed country governments.

The problems of excess leverage can be shifted, but they can’t be eliminated by government action.  I am repositioning my portfolio into companies that can survive the worst (hopefully), largely because I don’t think the present government policies will work in the intermediate-term.

Back to the crisis.  I want to be a bull, really.  I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.  I have used that for profit in the past.  I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.  For more, consider the discounts on closed-end funds — they are lower than ever.  Or, consider that the IPO market is closed.  Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.  The yield curve of the US is wide.  Fed policy is accommodative; don’t fight the Fed.  Consider that well-respected value investors like Marty Whitman are finally excited about the market.  Credit spreads are at record highs in the money markets and in the corporate bond markets.  Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.  I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.  I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.  If that is the case, we should see many abnormalities:

• The Treasury has shifted the TARP plan in order to recapitalize banks.  Good move, if late.
• Similar things are afoot in the UK and Germany.
• Many European banks are in trouble.

This is a global crisis, affecting most governments and firms.   Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.   I can dig up the references at RealMoney if necessary.  Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?  If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

Some people don’t like the concept of blame.  They view it as useless because it wastes time in looking for a solution.  I will tell you differently.  Blame is useful because it identifies offenders, which is the first step in eliminating the problem.  The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.  This was a good discussion, unlike many that I hear.  But the discussion (on NPR) eventually focused on “who should we blame?”  Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.  For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.  Rates were reduced before significant pain was felt by those who had borrowed too much.  The 1% Fed funds rate in 2003 was the pinnacle of that effort.  It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.  Gotta do that.  Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.  They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.  The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.  Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.  I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.  There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.  Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).  In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.  Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.  Hucksters.

3) Lenders steered borrowers to bad loans.  There was often implicit fraud, and in some cases, fraud.  The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.  What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?  Regardless of the housing price mania, you should have gone slower, and done more homework.  Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.  They just sold it away.  Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.  They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.  Many hoped to make money after joining private industry later.

12) America.  We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.  This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.  Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.  As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.  In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.  It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.  Capitalistic economies are unstable by nature!  Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.  Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.  Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.  It is hard to write about what could go wrong in the markets.  Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.  The system is biased in favor of happy talk.  Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.  Maybe our financial interests made us look like we were talking our books.  I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.  Now I am getting my just desserts.

This is an incomplete list.  I invite you to add others to the list in your comments.

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.  Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.  That’s an estimate on my part.  Why does balance sheet quality at the Fed matter?  If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.  Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”  I know Tyler and de Tocqueville said something like that as well.  At a time like this there are a lot of demands on the public treasury, and they are growing:

• U.S. May Help Private Funds To Purchase Troubled Assets
• Fed Will Lend Directly to Corporations

There is a trouble here.  In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?  This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.  As in the Great Depression, there was too much debt financing of assets.  The debt was more liquid than the assets, as well.  Borrow short, lend long.  Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).  Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.  That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

• Inflation when the Fed monetizes the debt,
• Depression from vastly increased taxes,
• Debt repudiation (whether internal, external, or both), or
• Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)  No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.  Trouble is, we don’t internally fund our debts.  At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.  Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.  Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.  Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.  There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.  My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”  The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.  I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.  Yeah, the pain’s gotta go someplace

Okay, so 16 minutes after my last post, Ben Bernanke says he will consider more rate cuts.  Nice, and toss in the commentary that sound like the Fed is taking signals from the TIPS market on inflation, as well as the commentary in the minutes that some members were leaning toward cuts in the Fed funds rate.

The key here is how much of the loosening they allow to work its way into the banking system, versus how much they put into the intervention programs.  So far, it hasn’t been much.

These are the times that try my soul as a portfolio manager.  During crises, I am forced to make tradeoffs of the short-, intermediate-, and long-terms.

• Short-term: technical oversold/overbought-ness.
• Intermediate-term: valuation levels.
• Long-term: what industries benefit from economic change?

This is a difficult balancing act.  What makes matters more complex here is trying to understand what impact the actions of the Fed/Treasury are likely to have on the Dollar.  I hope to have another post up on the balance sheet of the Fed, for now, here’s the graph that Ron Smith called “the hockey stick.”

As I note in the graph above, the changes are even larger than the change in the weekly average figures.  Now, this isn’t presently going to be inflationary, because the Fed is (sort of) acting as an agent for the US Treasury in bailing out lending markets.  The US Treasury creates T-bills or notes, gives them to the Fed, and the Fed uses them as collateral in their collateralized lending programs.

The difficulty comes here: it’s easy to create these programs, but hard to shut them down.  Now the Fed will buy commercial paper.  Talk about unbacked paper money, CP is unsecured by any assets of the company receiving the loan.  jck at Alea rightly calls this not-so-wee beastie the Super-SIV.  As I commented there: